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In a recent article on MarketWatch, Chris Martenson asserts that the Fed’s low interest rate policy and quantitative easing in recent years is deliberately stealing from savers. This article has elicited a big response, with almost 800 comments and almost 2000 likes on Facebook. The key point of the article is that the Fed’s policy of holding down interest rates to stimulate the economy has reduced the income provided by Treasury bonds, savings accounts, and certificates of deposit (CDs) to extremely low levels. In this way, the Fed’s policy can certainly be viewed as harmful to people trying to live on the income from bonds and other very low risk investments. This Fed-bashing rhetoric is far from the whole story, though.

The total impact of very low interest rates on savers and conservative investors is somewhat more complex than the MarketWatch piece suggests. Subdued inflation in recent years, one of the reasons that the Fed cites for keeping interest rates low, also means savers are seeing lower rates of price increase in the goods and services they buy. With very low current inflation, you simply don’t need as much yield as when inflation is higher. It would be wonderful for conservative investors to have low inflation and high yields from risk-free accounts, but that situation is effectively impossible for extended periods of time. All in all, low inflation is typically a good thing for people living in a fixed income.

Another effect of continued low interest rates is that bond investors have fared very well. The trailing 15-year annualized return of the Vanguard Intermediate bond Index (VBMFX) is 5.4%, as compared to 4.5% for the Vanguard S&P 500 Index (VFINX). Falling rates over this period have driven bond prices upwards, which has greatly benefitted investors holding bonds over this period.

One interesting related charge leveled by the MarketWatch piece (and also in a recent New York Times article) is that the Fed policy has exacerbated income inequality and that the wealthy are benefitting from low rates while less-wealthy retirees living on fixed incomes are being hurt. Low interest rates have helped the stock market to deliver high returns in recent years and it is wealthier people who benefit most from market gains. In addition, wealthier people are more likely to be able to qualify to refinance their mortgages to take advantage of low rates. The implication here is that less wealthy people cannot afford to take advantage of the benefits of low rates and that these people, implicitly, are probably holding assets in low-yield risk-free assets such as savings accounts or CDs. This is, however, somewhat misleading. Poorer retired households receive a disproportionate share of their income from Social Security, which provides constant inflation-adjusted income.

While investors in Treasury bonds, savings accounts, and CDs are seeking riskless return, money held in these assets does not help to drive economic growth, and this is precisely why the Fed policy is to make productive assets (in the form of investments in corporate bonds and equity) more attractive than savings accounts and certificates of deposit. So, the Fed is attempting to drive money into productive investments in economic growth that will create jobs and should, ultimately, benefit the economy as a whole. One must remember that the Fed has no mandate to provide investors with a risk-free after-inflation return.

It is certainly understandable that people trying to maintain bond ladders that produce their retirement income are frustrated and concerned by continued low interest rates and the subsequent low yields available from bonds. Given that inflation is also very low, however, low bond yields are partly offset by more stable prices for goods and services. It is true that the Fed’s policies are intended to get people to do something productive with their wealth like investing in stocks, bonds, or other opportunities. It is also the case that older and more conservative investors world prefer to reap reasonable income from essentially risk-free investments. Substantial yield with low risk is something of a pipe dream, though. Investors are always trying to determine whether the yield provided by income-generating assets is worth the risk. We may look back and conclude that the Fed’s economic stimulus was too expensive, ineffective, or both, but this will only be clear far down the road.

This is the eighth installment in our series on how individual investors can assess their financial health

With investment gains, as with other types of income, it’s not how much you make that ultimately matters, but how much you keep. In other words, you only get to spend what’s left after you pay taxes. There are various ways to make your investments tax efficient, and it’s crucially important that you know what they are.

To make sure you don’t incur an excessive tax bill from your investing, take the following steps:

1) Avoid realizing short term capital gains.

2) Make full use of tax-advantaged accounts.

3) Harvest your losses.

4) Match assets to account type.

5) Choose tax efficient mutual funds.

Avoid Realizing Short Term Gains

Selling an investment that you have held for less than a year at a profit triggers short term capital gains, and the tax rate for short term gains is markedly higher than for long term gains. Short term gains are taxed as ordinary income, while long-term gains are taxed at lower rates. The difference between the tax rate on your long term versus short term gains depends on your tax bracket, but it is usually sensible to hold investments for at least a year, although this must be considered in light of the need to rebalance.

Make Full Use of Tax-Advantaged Accounts

There are a number of types of investment accounts that have tax advantages. There are IRAs and 401(k)s, which allow investors to put in money before taxes. These accounts allow you to defer taxes until you retire, whereupon you will be taxed on the money that you take out. By paying taxes later, you get what amounts to a zero interest loan on the money that you would ordinarily have paid in taxes.

Another alternative is Roth IRAs and Roth 401(k)s. In these accounts, you put money in after tax, but you are not taxed on the future gains. If you have concerns that tax rates will be higher in the future, the Roth structure allows you to essentially lock in your total tax burden.

529 plans for college savings have tax advantages worth considering. While you pay taxes on 529 contributions, the future investment gains are not taxes at all as long as the money is used for qualified educational expenses. There may also be additional state tax incentives offered to residents, depending upon your home state.

Harvest Your Losses

If you make a profit by selling a security, you will owe taxes on the gain. However, if you sell security in a taxable brokerage account at a loss, the loss can be used to offset realized gains and can even offset up to $3,000 in ordinary income. If you then wait more than a month, you can buy the same position in the losing security and have reduced or eliminated your tax bill on the gain simply by selling the losing position and then waiting more than a month before buying that security back. Alternatively, you might buy another similar security to the one that you took a loss on and then you don’t have to wait a month. The key in this latter approach is that you can buy a similar but not functionally identical security if you want to take a loss and then immediately buy another security back.

It should be noted that tax loss harvesting does not eliminate taxes, but defers them into the future. In general, paying taxes later is preferable to paying them today.

Matching Assets to Account Type

Different types of investment assets have different tax exposure, so it makes sense to put assets into the types of accounts in which taxes are lowest. This process is sometimes referred to as selecting asset location. Actively managed mutual funds are most tax efficient in tax deferred accounts, as are most types of bonds and other income producing assets. The exceptions are those asset classes that have special tax benefits. Income from municipal bonds, for example, is not taxed at the federal level and is often also tax free at the state level. Holding municipal bonds in tax deferred accounts wastes these tax benefits. Qualified stock dividends are also taxed at rates that are lower than ordinary income, so qualified dividend-paying stocks typically make the most sense in taxable accounts. Real estate investment trusts, on the other hand, are best located in tax deferred accounts because they tend to generate fairly high levels of taxable income.

Choose Tax Efficient Mutual Funds

When mutual fund managers sell holdings at a profit, fund investors are liable for taxes on these realized gains. The more a fund manager trades, the greater the investor’s tax burden is likely to be. Even if you, the investor, have not sold any shares of the fund, the manager has generated a tax liability on your behalf. It is even possible for investors holding fund shares that have declined in value to owe capital gains taxes that result from one or more trades that the manager executed. You can minimize this source of taxes by either investing in mutual funds only in tax deferred accounts or by choosing funds that are tax efficient. Index funds tend to be very tax efficient because they have low turnover. There are also funds that are managed specifically to reduce the investor’s tax burden. One academic study found that funds engaged in tax efficient practices generate higher returns than peers even on a pre-tax basis.

Don’t Pay More Tax Than You Have To

Everyone needs to pay their fair share of taxes. But if you manage your investments with a consideration of tax consequences, you can avoid paying more tax than is required. If the various considerations outlined here seem too complicated, a simple allocation to a few index funds will tend to be fairly tax efficient. That is a reasonable place to start.

An old adage about tax planning is that a tax deferred is a tax avoided. In general, the longer you can delay paying tax, the better off you are. The various forms of tax deferred savings accounts are very valuable in this regard.

While it is more interesting looking for productive investment opportunities, spending a little time understanding how to minimize your tax burden can help to ensure that you actually get to spend the gains that you make.

This is the second installment in our series on how individual investors can assess their financial health.

The starting point for any discussion of a household’s financial health is to evaluate current savings and savings rates in the context of financial goals. The three largest expenses that most families will face are buying a home, paying for college, and providing income in retirement. Setting specific savings targets and timelines is a key step in increasing your ability to meet these goals.

To determine whether you are saving enough to pay for one or more of these goals, consider the following factors:

Expected total cost of goal

When the money is needed

Current amount saved for the goal

Expected annual rate of saving towards the goal

How much risk to take in investing to meet the goal

Retirement

A good first step for estimating how much you’ll need for retirement—and how you’re doing so far—is to try Morningstar’s Retirement Savings Calculator. This tool uses a range of sensible assumptions (which you can read about in the study from which it was developed) to estimate whether you are saving enough to retire. The study accounts for the fact that Social Security represents a different fraction of retirement income for households at different income levels and assumes that investments are consistent with those of target date mutual funds. The calculator scales income from your current age forward, based on historical average rates of wage growth.

The calculations assume that you will need 80% of your pre-retirement income after subtracting retirement contributions, and that you will retire at age 65. The estimated future returns for the asset allocations are provided by Ibbotson, a well-regarded research firm (and wholly owned subsidiary of Morningstar).

The final output of this model is a projected savings rate that is required for you to meet the target amounts of income. If this is less than you currently save, you are ahead of the game.

College

There are enormous variations in what a college education costs, depending on whether your child goes to a public or private institution and whether those who choose public schools stay in-state. There is also a trend towards spending two years at a community college before transferring to a larger comprehensive university. estimates that the average annual all-in cost of attending a public four-year university is $23,000 per year, while the cost of attending a private four-year university averages $45,000 per year. This includes tuition, room, board, books and other incidentals. It is worth noting, however, that the all-in cost of private universities are often far above $45,000 per year. The University of Chicago has an all-in cost of $64,000 per year. Yale comes in at $58,500.

Every college and university has information on current costs to attend, as well as a calculator that estimates how much financial aid you can expect to be given, based on your income and assets. There are a variety of ways to reduce the out-of-pocket cost of college including work-study, cooperative education programs, and ROTC. There are also scholarships, of course.

College tuition and fees have been rising at about 4% per year beyond inflation for the past three decades. With inflation currently at about 2%, the expected annual increase in college costs is 6%.

To be conservative, assume that money invested today in a moderate mix of stocks and bonds will just keep up with inflation in college costs. Vanguard’s Moderate Growth 529 plan investment option has returned an average of 6.9% per year since inception in 2002 and 6.4% per year over the past ten years. In other words, $23,000 invested today will probably pay for a year at a public four-year university in the future. You can invest more aggressively to achieve higher returns, but taking more risk also introduces an increased exposure to market declines.

Using the simple assumption that money invested today in a moderately risky 529 plan or other account is likely to just keep pace with cost inflation makes it easy to figure out how you are doing in terms of saving. If you plan to pay the cost of your child’s four-year in-state education and you have $46,000 invested towards this goal, you are halfway there.

Buying a Home

A house is a major financial commitment—one of the most significant that most people make. Unlike retirement or education, there is an alternative that provides the same key benefits: renting.

For people who decide to buy, a key issue is how much to save for a down payment. The amount that a lender will require depends on your income, credit score, and other debts. Zillow.com provides a nice overview, along with an interactive calculator of down payment requirements. This tool can help estimate how all of the factors associated with obtaining a mortgage can vary with the down payment.

In general, the goal is to have a down payment ranging from 5% to 20% of what you plan to spend on a home. By experimenting with the calculator at Zillow, you can determine how much house you can afford and how much you will need to put down. A down payment of 20% or more is the most cost-effective route because smaller down payments require that you buy mortgage insurance, which adds to the monthly payment.

There are several alternatives for investing a down payment fund. The primary consideration, however, is whether you are willing to adjust your timeframe based on how the market performs. If you are committed to buying a house within one to three years, you really cannot afford to take on much risk. If you are looking at a timeframe of five years or more—or if you hope to buy in one to three years but you are comfortable delaying if market returns are poor—you can afford to take more risk. There is no single answer for everyone.

If you are investing only in low-risk assets, however, estimating how much you need to save each month for a required down payment is straightforward enough, because the current expected rate of return on safe assets is close to zero.

USA Today ran a story in March on the changing nature of retail banking in America. This sounds kind of boring, perhaps, but it has broad implications both for bank clients and, potentially, for investors. The gist of the story is that banks are closing retail branches in small towns. A lack of traditional banking services is not a rural phenomenon, however, with substantial populations of people in urban areas who do not use traditional banks. For an informative interactive tool that allows you to explore the populations of people lacking key financial services, see here. There is a substantial population of people who have little or no access to traditional bank services (the under-banked or the un-banked), and it would seem that this population is likely to continue to grow if banks close their smaller retail branches. The solution, I believe, is that online banking services will serve the under-banked and un-banked, just as they have in the developing world.

In general, poorer households hold little if any assets in savings accounts and primarily use banks to cash checks. Banks don’t make money from check cashing, so they have a hard time profitably serving these customers. With interest rates at or near record lows, even bank clients with meaningful levels of savings provide little in the way of income to banks. And banks, not surprisingly, are focusing on wealthier clients as the way to boost revenues. The goal is to sell more profitable investing and financial planning services to wealthier clients. As the large banks try to move up-market in terms of products and services that they offer, it seems likely that an increasing number of less-wealthy Americans are quite likely to have less access to traditional bank services.

What does the future of retail banking look like? First, it seems inevitable that serving less-wealthy clients in physical branches will continue to be a relatively unattractive business. Second, check cashing and payday lending businesses—alternatives to traditional banks–will probably continue to grow. Lisa Servon, a professor of Urban Policy, argues that payday lenders provide a valuable service and that the industry is unfairly demonized. If people need to borrow money and don’t have access to a traditional bank, a payday loan may be worth the cost. Third, the increasing role of online banking and bill payment among the middle class reduces the time that customers spend in physical branches. There are a range of perspectives on the future of retail banking (see here and here).

My belief is that physical retail bank branches will largely disappear. If you really want or need to go to a physical branch – to access your safety deposit box, for example – you probably don’t mind driving. Otherwise, what does the retail bank really provide that you cannot get online? Bank analyst Dick Bove actually makes the case that quality customer service at branch locations is not necessarily even a good sign for investors. He posits that bank employees generate more revenue for the bank by spending their time “selling products”, rather than by trying to solve problems for customers.

As the systems for mobile banking expand, this could dramatically help the un-banked and under-banked as well as displacing retail banking services for the more affluent. In the developing world, for example, mobile banking (banking services provided via mobile phone) is already a dominant force. Businesses can pay their employees via mobile banking, entirely removing the need to cash a physical check. The M-Pesa mobile payment business now serves seventeen million people in Kenya alone. Mobile payments were the fastest growing form of payments in China in 2013, totaling $1.6 Trillion. There are also a host of non-banking firms that are providing services that look like banking. There is no obvious reason that some or all of these types of services cannot expand into the U.S. to serve the un-banked and then move up-market to replace some or all retail banking services to more affluent customers. The current situation reminds me of a number of cases of technological innovation discussed in The Innovator’s Dilemma, the ground-breaking book by Clayton Christensen. The book argues that new technologies first succeed not by displacing entrenched providers, but rather by first meeting the needs of an un-served population. After the new technology has proven its worth, it then moves up-market to disrupt the traditional business model. The current state of mobile banking is in serving the developing world, where people often have little or no access to traditional banks at all. The enormous growth in these businesses suggests that the future is to move up the food chain. Mobile payment technology and usage is growing in the U.S., albeit slower than expected. Accenture projects that as much of 35% of retail banks’ revenues could be lost to a range of online services providers by 2020. Given that retail banks in the U.S. are seeing their traditional businesses struggle along with less use of their branch offices, coupled with a growing population of potential clients who the retail banks do not serve at all, mobile banking looks to me like the future of retail banking.

In the financial advisory business, one of the most pressing and controversial topics is how much money people need to save during their working years in order to provide for long-term retirement income. The research on this topic has evolved quite a lot in recent years, and a recent issue of Money magazine features a series of articles representing the current view on this critical topic. These articles, based around interviews with a number of the current thought leaders on this topic, deserve to be widely read and discussed.

The series of articles in Money kicks off with perspectives by Wade Pfau. Pfau’s introductory piece suggests a difficult future for American workers. A traditional rule-of-thumb in retirement planning is called the 4% rule. This rule states that a retiree can plan to draw annual income equal to 4% of the value of her portfolio in the first year of retirement and increase this amount each year to keep up with inflation. Someone who retires with a $1 Million portfolio could draw $40,000 in income in the first year of retirement and then increase that by 2.5%-3% per year, and have a high level of confidence that the portfolio will last thirty years. It is assumed that the portfolio is invested in 60%-70% stocks and 30%-40% bonds. The 4% rule was originally derived based on the long-term historical returns and risks for stocks and bonds. The problem that Pfau has noted, however, is that both stocks and bonds are fairly expensive today relative to their values over the period of time used to calculate the 4% rule. For bonds, this means that yields are well below their historical averages and historical yields are a good predictor of the future return from bonds. The expected return from stocks is partly determined by the average price-to-earnings (P/E) ratio, and the P/E for stocks is currently well-above the long-term historical average. High P/E tends to predict lower future returns for stocks, and vice versa. For a detailed discussion of these relationships, see this paper. In light of current prices of stocks and bonds, Pfau concludes that the 4% rule is far too optimistic and proposes that investors plan for something closer to a 3% draw rate from their portfolios in retirement. I also explored this topic in an article last year.

Income inequality is increasingly acknowledged as a key economic issue for the world. The topic is a major theme at Davos this year. Economic inequality is also an increasingly common topic in U.S. politics.

A new study has found that economic mobility does not appear to have changed appreciably over the past thirty years, even as the wealth gap has grown enormously. The authors analyzed the probability that a child born into the poorest 20% of households would move into the top 20% of households as an adult. The numbers have not changed in three decades.

On the other hand, there is clearly a substantial accumulation of wealth at the top of the socioeconomic scale. The richest 1% of Americans now own 25% of all of the wealth in the U.S. The share of national income accruing to the richest 1% has doubled since 1980. In contrast, median household income has shown no gains, adjusted for inflation, since the late 1980’s and has dropped substantially from its previous peak in the late 1990’s.

I have known Phil DeMuth for a number of years and I admire his common sense and views on many topics. Phil authored the recently-published book The Affluent Investor that fills a need in the crowded shelves of investment books. As a financial advisor to high-net-worth families, Phil brings valuable perspective to investors who have built substantial portfolios and seek to protect and grow their wealth effectively. Continue reading →

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